One of the most commonly cited benefits of a commercial real estate investment is the tax benefits associated with its “pass through” organizational structure. While this is certainly true, there is often some confusion about what exactly this means.
In this article, we will define what a pass through structure is, how it works, and how it benefits real estate investors from a tax perspective. By the end, readers will have a greater understanding of the pass through structure and should be able to determine if it is a good fit for their own investment objectives.
At First National Realty Partners, we use pass through entities in all of our real estate investment transactions. Doing so serves to maximize the tax benefits for our investors. To learn more about our current investment opportunities, click here.
Pass-Through Structure Explained
In commercial real estate, nearly all properties are bought and sold through special purpose entities known as Limited Liability Companies – LLCs for short. There are two reasons why this is done: liability protection and taxes.
With regard to liability, investors like the LLC structure because it provides a certain level of asset protection in the event of a loss. In such a circumstance, creditor claims are limited to the assets of the LLC only, which means that the maximum loss possible is limited to the investment in the LLC. It should be noted, however, that every transaction is unique and there are certainly exceptions to this rule. It is always a best practice to seek advice from a qualified real estate attorney on each specific situation.
From a tax standpoint, the LLC is taxed as a partnership, which means that it avoids the double taxation commonly associated with corporations. Practically, this means that income and expenses pass through the LLC and are distributed to real estate investors who are subject to income tax at the individual level. To illustrate this point, an example is helpful.
Pass Through Structure Example
Suppose that two individuals get together to purchase a rental property. To do so, they create an LLC where they each have 50% ownership.
In this example, suppose that the property’s total income is $100,000, which is derived from rents and fees.
From the total income, operating expenses like property taxes, insurance, common area maintenance, and utilities are deducted. For the purpose of this example, assume that total expenses are $50,000.
Total income, less total expenses equal the property’s net operating income, which is an important real estate performance metric. Given the income and expenses described above, NOI would be $50,000.
From NOI, debt service is deducted. In this example, assume debt service is $25,000, which leaves $25,000 as pre-tax income available for distribution. Because each real estate investor owns 50% of the property, they are each entitled to 50% of the pre-tax income or $12,500.
This $12,500 is distributed to each individual investor where it is combined with their other income and expenses to establish their total tax liability. Under IRS rules these distributions are reported on a document known as a “K-1“, which is produced by the LLC and provided to all investors.
The bottom line is this, LLCs are known as pass through entities because they are not taxed at the entity level. Instead, income and expenses flow through them and is distributed to investors each tax year. For real estate investors, these distributions are categorized as taxable income on their tax return and combined with their other sources of income and expenses to determine their total tax liability.
What Are Pass Through Leases?
One additional wrinkle to the LLC pass through structure is the type of real estate lease agreement that is signed by the tenants. There are two major types.
In a gross lease structure, the tenant pays one rental amount each month and the landlord pays all of the property’s operating expenses. The other type is known as a net lease, where the tenant pays one base rental rate plus some portion of the property’s operating expenses. For example, a triple net lease requires the tenant to pay rent plus the three major categories of operating expenses: real estate taxes, insurance, and maintenance.
Net leases are sometimes referred to as pass through leases, because operating expenses pass through them to be paid by the tenant. From a real estate investment perspective, this is important because it can add some additional complexity to the accounting process for income and expenses.
How Pass-Through Affects Investors
As described above, pass-through entities impact individual real estate investors because they are the ones responsible for paying taxes on their share of income received.
Each individual investor’s tax situation is unique, which means that the tax liability associated with the distributions received from rental real estate is different for everyone. One real estate investor may be a high income earner, which means that their tax rate could be higher than another investor whose income puts them in a lower tax bracket.
Because each taxpayer’s situation is unique, it is always a best practice to work with a CPA to ensure that all tax rules are followed and that all appropriate liabilities are paid.
Pass-Through & Private Equity Real Estate
For individual real estate investors, one of the major benefits of working with a private equity real estate firm is that they bring a significant amount of operational expertise to the deal. They know exactly how to structure the deal for tax purposes and they handle all of the necessary K-1 reporting for distributions made to individual investors.
In short, they are a valued partner whose job is to structure the most tax efficient transaction on behalf of their investors. In most transactions, this involves the creation of a pass through entity.
Summary of Real Estate Pass-Through
A typical commercial real estate investment is bought and sold through a limited liability company, which is a separate legal entity that offers the liability protection of a corporation and the tax benefits of a partnership.
For a commercial property, income and expenses “pass through” the LLC and is distributed to investors who are taxed at the individual level. This structure avoids the double taxation of a corporation.
Some transactions also include properties with “pass through leases.” These are net leases where the tenant is required to pay a base rent plus some amount of the property’s operating expenses. In other words, the expenses pass through the lease to become the tenant’s responsibility.
Working with a private equity firm helps real estate investors maximize the tax efficiency of the investment. They have the operational knowledge and expertise required to set up the deal in the most tax efficient manner.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
